Trust Issues: Pre- and Post-Nuptial Clauses

Tax Returns

Tax returns are a common issue addressed in matrimonial agreements. These provisions should contemplate a range of trust considerations — often more than some practitioners might initially think. For example, a common trust structure is referred to as a “grantor” or “defective” trust in which the settlor creating the trust is taxed on all trust income. Another technique, referred to as a beneficiary defective irrevocable trust or a “BDIT,” is created by a third party, such as a client's mother, but structured so that the beneficiary (e.g., your client) is taxed on trust income even though not the grantor. Some of these trusts (if formed in a jurisdiction that permits this right) may include a tax reimbursement clause that provides an independent trustee the authority, but not the requirement, to reimburse for taxes. This power might also be surrendered (turned off), or triggered (i.e., not effective initially but made effective after the trust was initially formed, and perhaps after the matrimonial agreement was executed). The variability of these provisions can make drafting a matrimonial agreement complex, but administering it even more so. The following is sample language for marital agreements pertaining to how income tax payments and refunds should be allocated by the parties:

If in connection with any joint income tax returns filed by the couple heretofore or hereafter, there is any deficiency assessment, the amount ultimately determined to be due thereon, including penalties and interest, shall be paid by the parties in proportion to his/her income (which may include income of pass through trusts or entities that are not treated as martial income), unless and to the extent that same has been caused by the failure or neglect of a party to disclose any income which should have been included in such returns, in which event and to that extent the party so failing or neglecting to disclose shall bear such expense to the extent allocable to such failure or neglect. Each party agrees to cooperate fully with the other in the event of any audit or examination by a taxing authority of the said joint tax returns and agrees to furnish to the party being examined or his or her designees, promptly and without charge, such authorizations, powers of attorney, papers, records, documents and information as may be reasonably appropriate in connection with such audit or examination; however, in the event of any trust or pass through entity whose income is reflected on the joint income tax return but excluded as non-marital income hereunder, the spouse to whom such income belongs, or the trustee, officer, director, manager or other appropriate person of such trust or entity of that spouse, shall handle such audit. In the event a refund is hereafter paid under the parties' joint income tax returns, the refund shall be divided by the parties in the same proportion as their respective Separate Property shall have generated such refund for the respective year.

If either party has a trust that is characterized as a grantor trust, or an interest in a pass-through entity, or any income from separate property, and if the other spouse's assets are used to pay for income tax on income attributable to such separate property, then such payment of taxes shall not provide any right or claim to the subject entity, trust or property. Rather, to the extent that a spouse's assets are used to pay taxes on income attributable to the other spouse's separate property, he/she shall be entitled to reimbursement in an amount equal to the taxes paid in connection thereto. If either party is a grantor of a trust that permits now or in the future the trustee to reimburse that spouse as grantor for income tax costs he or she paid on income from the trust, neither party shall have any right to demand such reimbursement nor shall either party have any claim if that right to reimbursement is waived or terminated.